How options trading could be fueling a stock market bubble

The stock market is near record highs, and optimism abounds. Coronavirus vaccines are finally getting jabbed into arms. Interest rates are at historic lows. And the Democrats who control Washington are expected to pour another trillion dollars or so into the still-struggling economy.

But it’s getting increasingly difficult to overlook signs that investors are taking things too far, too fast.

The latest signal is from the somewhat obscure market for stock options, where traders can place bets with brokers that a stock will rise or fall. Speculation has reached a frenzied level not seen since the tail end of the dot-com boom two decades ago. That enthusiasm is having a growing influence over the regular stock market itself.

“If you’re betting on sports, the amount of people on one side of the bet or another can only influence the odds, not the outcome,” said Steve Sosnick, chief strategist at Interactive Brokers in Greenwich, Connecticut, a major options brokerage. “In the case of options, it can actually change the outcome.”

Over the past year, and even during the deep uncertainty that flummoxed the market at the start of the pandemic, individual investors — often with little experience — have been pouring into the market. What has lured them varies: free trades, extra cash from relief payments or even an itch for action with most sports leagues shut down.

Options trading hit a record in 2020, with some 7.47 billion contracts traded, according to the Options Clearing Corp. That’s a 45% increase compared with the previous record, set in 2018.

Much of this money has come from small-time traders hoping to make fast gains by buying “calls” — bets on rising markets — set to expire quickly.

The skew is evident in something called the put-call ratio, which shows how many contracts are betting on gains compared with those betting on losses through “put” options. On Friday, the 50-day moving average of that ratio was 0.42, near the lowest level in two decades. The last time it was this tilted for this long was 2000, meaning options investors are more optimistic, or greedy, than they have been in more than two decades.

Together, the sudden growth in options trading and the unbridled optimism of the buyers is a market-moving force in itself.

How options can drive the market.

An individual who wants to make a bet that a stock price is going to rise can buy a call option at a brokerage firm. This contract gives the buyer the right — but not the obligation — to buy a stock at a given price at some point in the future. If the share price is higher on that date, the buyer can purchase the shares using the contract, then sell them for a profit.

But just as the buyer stands to benefit from a rising share price, the dealer who sold the contract stands to lose.

Brokerage firms make money by charging fees on products, not by predicting where share prices go. So to hedge their risk on a given contract, they buy a calculated percentage of the stock they would be forced to sell if the buyer ends up making money on the bet.

But as the stock prices rise, brokers must buy more shares to keep their hedges in balance. And buying more shares helps push share prices up.

In other words, rising share prices boost demand for shares even further, all because of market dynamics — not because of a fundamental view that the company’s business prospects are improving.

“In this situation, dealers are amplifying price movements,” said Andrea Barbon, an assistant professor of finance at the University of St. Gallen in Switzerland, who recently co-wrote a paper that analyzed the relationship between the options markets and market volatility.

The result can be an options market that itself has become a generator of share-price momentum and stocks that appear increasingly untethered from bedrock fundamentals, like expectations for corporate earnings.

“The fundamentals aren’t the driver. That’s not what matters anymore,” said Charlie McElligott, a market analyst with Nomura Securities in New York. “It’s the scale and the growth of the options market as this lottery ticket vehicle, which is especially magnified right now because of the retail frenzy.”

Will the market correct for the rise in prices?

The overwhelming optimism of stock options investors — and the chance that they are fueling a feedback loop of ever-escalating stock prices — is one of the reasons some analysts are concerned that a bubble might be building in the market.

If history is any guide, such bubbles tend not to last. The frenzy back in 2000 was followed by a roughly 2 1/2-year downturn as the stock market plunged 40%.

The downturn doesn’t have to be that dramatic. In August, the put-call ratio tilted hard as bullishness took hold.

Stocks then suffered a sudden tumble in early September, with the S&P 500 dropping more than 7% over three weeks. The sell-off was led by the same giant technology companies — including Microsoft, Amazon and Alphabet, Google’s parent, — that had led much of the market’s monthslong rally.

Few analyst saw a fundamental reason for the drop.

“High levels of speculation usually do run their course,” Sosnick said.

But for now there are few indications that investors have had their fill.

Since the sharp setback for tech stocks in September, retail traders have redoubled their interest in buying single-stock options, which have become especially popular among online amateurs who gather on Reddit and Discord to swap ideas and fawn over screenshots of both purported wins and gut-wrenching losses.

The momentum will probably last until markets turn down and these newly minted traders experience painful losses that, for many, will be the first in what has been an extremely short investing career.

“Are these the types of people who have the ability, the acumen, the pain tolerance to stay disciplined and not create a stampede of new investors out the door?” McElligott asked.

If they flee, it would only magnify any fall.

“That’s where it can get combustible,” he said.